by Mert Buckley

A nonrecourse loan is a favorite of borrowers. It is a “secured loan that allows the lender to attach only the collateral, not the borrower’s personal assets, if the loan is not repaid.”

Gone and Back Again
Nonrecourse loans were popular in the 1980s, but disappeared when the real estate market faltered and streams of banks and savings and loans were closed. These loans re-emerged recently, mostly offered by institutional lenders such as insurance companies and Real Estate Investment Trusts (“REITS”). But they carry strict requirements and often inflexible terms as tradeoffs. Included in these tradeoffs are “carveouts” or exceptions where the borrower and its principals can become personally liable for some or all of the debt if one or more of the carveout events occurs. Some common examples of carveouts which cause personal liability in nonrecourse loans are: fraud; waste of the property; misappropriation of insurance proceeds, eminent domain or condemnation awards; failure to pay real estate taxes or insurance premiums; and intentional breach of material representations by the borrower or a guarantor.

Recent Experience
The commercial real estate market has been strong in recent years with few defaults to test the enforceability of these carveout provisions. But a recent case from Massachusetts has drawn nationwide attention among real estate lawyers and lenders. Blue Hills Office Park v. J.P. Morgan Chase Bank, 477 F. Supp. 2d 366(2007). In it, the court firmly enforced a carveout exception against loan guarantors.

What Happened
Blue Hills was a borrower with a $33 million nonrecourse loan secured by a mortgage and conditional guaranties of individuals which were triggered by certain carveouts. Blue Hills had a dispute with its neighbor over a zoning issue and the neighbor paid Blue Hills $2 million to settle the dispute. Blue Hills did not disclose the payment to its lender. Sometime later Blue Hills defaulted on the loan, and when the lender learned of the $2 million settlement, it sued the guarantors for liability on the entire deficiency of over $10 million.

The Results
The lender won because the guaranties said the individual guarantors would be liable for the full amount of the debt if the borrower failed to obtain lender’s prior consent to “any transfer of the mortgaged property or any interest therein.” The settlement payment for the zoning dispute was determined to be “proceeds” of the mortgaged property, so the guarantors breached the carveout terms when they didn’t get the lender’s consent to the settlement. As a result, they had to pay back the $2 million settlement and were liable for the entire $10 million deficiency.

Lesson
Borrowers and lenders both need to be mindful of the carveout provisions in nonrecourse loans – not only at the time of a default, but throughout the entire life of the loan. Actions taken while the loan is current can come back to haunt the borrower and its principals later down the road.

(Article appeared in Adams Jones August 2008 Newsletter)